THE MAN GIVETH AND TAKETH AWAY Trump & Puerto Rico

As markets awoke from their lugubrious snooze, they were met with a dilemma. What to do now that Trump in his visit to Puerto Rico suggested that he could make Puerto Rico’s debt vanish because that was what was needed to rebuild the country?

The state of Puerto Rico is calamitous with little infrastructure standing and a desperate housing shortage combined with virtually no power and no running water. The island needs a massive injection of assistance and money. The only problem is, Puerto Rico has only just restructured its debt after running into major repayment issues not so long ago. Trump is right. However, how would he do such a thing? And would the repayment/ forgiveness add to the already ballooning U.S. budget deficit and imperil his tax reform?

Muni traders did what needed to be done, they sold and they sold hard. The insurers of Puerto Rican debt saw their price slashed and a degree of uncertainty now prevails. The debt is now trading around 34 cents in the dollar. The bonds had traded earlier in the day at 30.5c.

Bond markets, however, were largely unaffected and so too equity markets. Equity markets extended their gains and hit new highs. The bond market, after a steady rally, sold off a little to finish unchanged. U.S. payrolls added 135k according to ADP data, and that was the source for the slight equity rally and a small discomfort for bonds. The increase, however, was the smallest monthly increase since October 2016. Bonds appear to be near a top and traders appear unwilling to sell. Liquidity and investor demand appears to soak up excess bonds when the U.S. bond market experiences a selloff.

Bonds are remaining extremely resilient at present and this may be because of the sheer weight of money sloshing around in the system as a result of QE.

What markets will have to figure out is what happens when this liquidity evaporates. After all, much of the equity gain has not been through productivity increases, new technologies or sales. It is as a result of easy money that allowed corporates etc to borrow money to increase dividends, buy back shares and pay their CEOs more money to artificially increase the share price.

This is a house of cards that may one day come crashing down. There is little increase in capex and productivity and wages remain significantly constrained. What happens next will be dependent on where money supply ends. It is interesting though that the ECB has asked banks to set aside a larger provision by way of cash for bad loans. The rules will be banks have two years to set aside funds to cover 100% of newly classified non performing unsecured debt and seven to cover all secured bad debt.

This is probably a good scenario for bonds. However, it is a very long-winded scenario.

Market Recap:

Equities: hit a new high. The S&P 500 climbed 0.1%, the Dow rose 0.09% to set a sixth successive record close, and the Stoxx 600 fell 0.1%

Currencies: the euro gained 0.2% and the pound rose 0.1%.

Bonds: held steady. The U.S. 10-year closed better by a point to close 2.328%. The U.S. bond curve was steady with the 2/10 closing at 85.1 bp, the 2/30 at 139.4 bp, and the 10/30 closed at 54.1 bp. The treasury closes were 2 -year closing at 1.475%, the 10-year at 2.328% and the 30-year at 2.87%.

Aussie Market Today:

Equity markets appear to be in a holding pattern and are most likely to have a slight rally today. U.S. bonds were steady and so too European bonds and this should allow Aussie bonds to rally a little. Short covering will continue. However as we head towards the end of the week, one should be mindful as a squaring ahead of the weekend is likely and this could lead to a selloff. The Aussie market remains constrained by offshore factors and those factors will dominate the direction of trading. Geopolitical risk has waned a little but still remains a significant risk.